Examiners Take a Comprehensive Approach to Reviewing Executive Compensation

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An increasing number of our community bank clients report that regulators are focusing significant examination effort on compensation policies and the related risk-assessments and controls. By now, most bankers are aware of the Consumer Financial Protection Bureau’s (“CFPB”) new rules regarding mortgage loan originator compensation that will go into effect in January of 2014. Banks that make residential mortgage loans will likely be reviewing their compensation policies with an eye toward compliance with those regulations long before the effective date. But even now, months before those rules go into effect, examiners are taking a much broader look at bank compensation policies – not just focusing on mortgage loan originators and consumer compliance, but also on a bank’s overall risk-assessments and controls related to all types of incentive compensation. Accordingly, as you think about reviewing mortgage compensation for compliance with the new CFPB rules, we encourage you to expand your review to incorporate the more comprehensive risk-assessment and mitigation components that your safety and soundness examiners will be looking for.

A good place to start when preparing for this type of evaluation is the framework that examiners have adopted for their own assessment. In this case, that framework is described in the joint banking agencies’ Final Guidance on Sound Incentive Compensation (“Compensation Guidance”). A copy of the Compensation Guidance can be found by following this link, and we recommend that you review this Guidance carefully in connection with any risk-based evaluation of your institution’s compensation practices. If you don’t have time to review the entire Guidance, however, then we hope that you will at least consider the following recommendations for compliance that we believe will be most important for community banks.

The regulators are not (yet) requiring any formulaic or one-size-fits-all approach or restrictions for incentive compensation policies of community banks. The joint bank regulatory agencies have clarified that their intent is not to dictate what institutions can and cannot pay to employees. Instead, the regulatory review of compensation arrangements for smaller institutions (generally, those institutions that are not considered by the regulatory agencies to be “large banking organizations”) has been based on facts and circumstances and focuses on risk-management, effective controls and strong corporate governance. Accordingly, you will want to be able to demonstrate that your bank’s compensation policies and practices address each of those three areas.

Regulators have adopted a broad scope with respect to employees deemed to be covered by their review. Consequently, your compensation risk-assessment should not be limited to incentive compensation of executive officers (i.e., “Reg O officers”), but instead, should encompass incentive compensation paid to any employee whose activities, either individually or in the aggregate with other employees, may expose your bank to material risk (e.g., loan officers with high lending limits relative to the organization’s overall risk tolerance).

Boards of Directors should make a conscious and well-documented effort to review and identify any material risk inherent in your institution’s incentive compensation policies. In particular, Boards should make a determination as to whether compensation arrangements encourage actions that result in greater short-term revenue or profits for the organization, without regard to risk. If the compensation arrangement is appropriately balanced, two employees who generate the same amount of short term revenue or profit should not receive the same amount of incentive compensation when the risks taken by those employees in generating that profit differ materially. In this situation, the employee who creates more risk for the organization should receive less, assuming everything else is equal.

It may be appropriate to form a formal compensation committee of the Board, or to have the full Board (excluding members of bank management) act as a compensation committee for the purposes of this review. If your Board does not already conduct regular compensation risk-assessments, we recommend that this review be performed as soon as possible, and the process should be repeated on at least a bi-annual basis.

Finally, where the Board (or Compensation Committee) determines that any incentive compensation policy is not aligned with the related risks, or where related internal controls or corporate governance practices are not consistent with safety and soundness, your Board should take immediate action to correct identified deficiencies. This may include revisions to existing policies, compensation agreements or the implementation of “clawbacks.” Be careful to document your efforts in this regard so that examiners can see that your institution has been proactive in identifying and mitigating compensation-related risks.

The above suggestions are only the tip of the iceberg where incentive compensation risk-assessments are concerned. If you are a member of your institution’s Board of Directors or Compensation Committee that is responsible for compensation and compliance, you should not stop reading here. For a better understanding of the Compensation Guidance and its requirements for compliance, we recommend that you read the Guidance in its entirety. Please also feel free to contact us if you have specific questions about your institution’s compensation practices or if you would like a more comprehensive summary of the Compensation Guidance discussed above.